ECN202: Macroeconomics
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ECN202: Macroeconomics
Circular Flow & Aggregate Supply-Aggregate Demand
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Circular Flow DiagramThe Circular flow diagram is comparable to a wiring or plumbing diagram for a house. Here is shows the flow of money in a modern economy, and in it you can see the four key players (Households, Firms, Government, and Foreigners) and the four macro markets in which these players conduct their business (labor, output, capital, and foreign exchange). For each market there is a S & D curve and price and quantity measures that we look into later. In the circular flow you just need to “follow the money” to understand how the macro economy functions and how shocks in any market spread to the other markets.
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Macro Markets, Players, & Indicators
Markets Demanders Suppliers Key Concepts
Outputcars
FirmsGDP, NI / CPI /
Productivity
Laborjob
Firms / Government
Employment / Earnings /
Unemployment
Capitalloan
Money supply / Interest Rates
Foreign Capitaltravel Foreign
Trade balances / Exchange Rates3
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Demand
Supply
Each Market has one of these
Q*
P*
Price
Quantity
Headlines Headlines are about are about
Price & Output Price & Output changeschanges
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ForeignersForeigners
Four Players
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Four Markets
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An overview of macro environment
Markets Demanders Suppliers Key Concepts
OutputFirms / Households /
Government / Foreign FirmsGDP, NI / CPI /
Productivity
Labor
CapitalFirms / Households /
Government / Foreign
Firms / Households / Fed / Foreign
Money supply / Interest Rates
Foreign Capital Buyers of US “stuff”
Sellers of US “stuff” Exchange rate8
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Demand
Supply
Foreign ExchangeForeign Exchange Market (US $s)
Q*
P*
Price = Exchangerate
Quantity = units of currency 9
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What is happening to the What is happening to the value of the US $ in value of the US $ in
these two graphsthese two graphs
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An overview of macro environment
Markets Demanders Suppliers Key Concepts
OutputFirms / Households /
Government / Foreign FirmsGDP, NI / CPI /
Productivity
Labor Firms / Government Households
Employment / Earnings /
Unemployment
CapitalFirms / Households /
Government / Foreign
Firms / Households / Fed / Foreign
Money supply / Interest Rates
Foreign Capital Foreign US
Trade balances / Exchange Rates12
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Demand
Supply
LaborLabor Market
Q*
P*
Price = wage
Quantity = Employment
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An overview of macro environment
Markets Demanders Suppliers Key Concepts
OutputFirms / Households /
Government / Foreign FirmsGDP, NI / CPI /
Productivity
Labor Firms / Government Households
Employment / Earnings /
Unemployment
CapitalFirms / Households /
Government / Foreign
Firms / Households / Fed / Foreign
Money supply / Interest Rates
Foreign Capital Foreign US
Trade balances / Exchange Rates
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Demand
Supply
CapitalCapital Market
Q*
P*
Price = Interestrate
Quantity = Funds $s
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What is happening here What is happening here to interest rates?to interest rates?
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Demand
Supply
OutputOutput Market
Q*
P*
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An overview of macro environment
Markets Demanders Suppliers Key Concepts
OutputFirms / Households /
Government / Foreign FirmsGDP, NI / CPI /
Productivity
Labor Firms / Government Households
Employment / Earnings /
Unemployment
CapitalFirms / Households /
Government / Foreign
Firms / Households / Fed / Foreign
Money supply / Interest Rates
Foreign Capital Foreign US
Trade balances / Exchange Rates19
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What is happening to What is happening to real GDP growth rate?real GDP growth rate?
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How does WW II seem How does WW II seem to divide the two to divide the two
periods?periods?
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Aggregate Supply & Aggregate DemandAggregate Supply & Aggregate Demand
You have now looked at the labor and output markets, and now we are going to look at the “picture” of the output market more carefully. This is the market for ALL goods and services – cars, lawyers, school, milk – and while it looks like the S&D graph, it is not. One thing is the same – if you follow the rules you will be OK. Now we will look at the AS-AD model economists use to understand the macro economy.
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AS-AD Analysis Cookbook Approach
1. Identify the participants1. AS: Suppliers (firms…)2. AD: Demanders ( firms, households,
government, foreigners)
2. Identify the determinants of behavior 3. Identify the appropriate curves
KNOW the AXES (variables)
4. Identify any special situation
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Determinants of aggregate supply (AS)
1. Number of inputs Capital, labor, resources
2. Costs of production Price of inputs / resources
Productivity / efficiency of resources
3. Price level
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Aggregate Supply Curve
P0
Q1
P1
Q0
PriceLevel
GDP
AS (depends on # and price of inputs & their productivity
AS has positive slope since higher prices coax out more supply
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What shifts the Aggregate Supply curve?
Change in any of the factors (other than price level) that affect Aggregate Supply will change the AS curve.
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Aggregate Supply Curve
P0
Q1
P1
Q0
PriceLevel
Quantity = GDP
When productivity increases @ each price Aggregate Supply has
increased and curve shifts to the right
AS
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Components of aggregate demand (AD)
Who buys American “stuff” in the output market?
1.(Households) Consumption Spending
2.(Firms) Investment spending
3.(Government) Government spending
4.(Foreigners) Export & Import spending
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Determinants of aggregate demand (AD)What affects demand for American “stuff”?
1.Consumption Spending (Households)Income, expectations, interest rate…
2.Investment spending (Firms)Profit, expectations, interest rate…
3.Government spending (Government)Policies, state-of-economy, interest rate…
4.Export spending (Foreigners)Income, expectations, exchange rate in ROW
5.Import spending (US firms & Householde)Income, expectations, exchange rate in US
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Aggregate Demand Curve
AD = C+I+G+X-M
P2
Q2
P1
Q1
AD has negative slope since higher prices mean there is less money to purchase “stuff”
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Aggregate Demand Curve
AD = C+I+G+X-M
P2
Q2
P1
Q1
When interest rates fall and demand for cars increases @ each price = increases Aggregate
Demand and the curve shifts to the right
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AD (C+I+G+X-M)
AS(# and price of inputs,productivity)
AS-AD Model of Output Market
Q*
P*
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We now have a model that helps us understand changes in the price level (CPI) and national output (GDP). We can use it to explain past changes or forecast future changes in these variables and it looks very much like the analysis of S&D. We need to look at how the economy adjusts to “shocks” to the system using the same technique.
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Use AS-AD model to explain the following headlines
a. a decrease in US consumer confidence that pushes consumption spending lower
b. a significant expansion in Asia that raises Asian demand for US exports
c. an increase in the productivity of American workers
d. China growth pushes oil prices higher
Get out that pad and draw the diagrams for each question before reading on
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a. Impact of decrease in US confidence that pushes consumption spending lower.
AD
AS
Cookbook approach1.Identify the participants - US consumers = AD2.Identify the determinants of behavior – Consumer confidence decrease reduced consumption spending3.Identify the appropriate curves - AD curve shifts in4.Result: lower GDP (recession) and lower inflation (price level)
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b. a significant expansion in Asia that raises Asian demand for US exports.
AD
AS
Cookbook approach1.Identify the participants - Asian demand for US exports = AD2.Identify the determinants of behavior – Expansion in Asia means more income = more demand for US exports3.Identify the appropriate curves - AD curve shifts out4.Result: higher GDP and higher inflation (price level)
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c. an increase in the productivity of American workers.
AD
AS
Cookbook approach1.Identify the participants - productivity of workers = AS2.Identify the determinants of behavior – Increase productivity = lower costs of production – increase AS3.Identify the appropriate curves - AS curve shifts out4.Result: higher GDP and lower inflation (price level)
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d. China growth pushes oil prices higher.
AD
AS
Cookbook approach1.Identify the participants - oil prices = AS2.Identify the determinants of behavior – higher oil prices raise costs of production – reduces AS3.Identify the appropriate curves - AS curve shifts in4.Result: lower GDP (recession) and higher inflation (price level)
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Note on oil price shock
In a more complete analysis you need to account for the fact the US imports a good deal of its oil and that demand for oil is inelatic so when the price goes up we do not cut demand much. In this case if the price of oil rises then US imports rise so we get the inward shift of the AS curve from higher production costs AND an inward shift in the AD curve because imports rise. In exams you should not worry about the more detailed analysis.
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Here are a few more examples
a. A rise in the value of the US $ pushes US imports higher
b. A rise in interest rates slows housing sales
c. Rise in housing prices raises household wealth
d. Business confidence falls lower spending on new equipment
Get out that pad and draw the diagrams for each question before reading on
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a. A rise in the value of the US $ pushes US imports higher
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b. A rise in interest rates slows housing sales
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c. Rise in housing prices raises household wealth
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d. Business confidence falls lower spending on new equipment
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See how you did
a. A rise in the value of the US $ pushes US imports higher – higher US imports affects AD – but be careful since Imports have a negative sign so higher imports reduces demand for US “stuff” – so AD decreases and shifts left.
b. A rise in interest rates slows housing sales- higher interest rates reduce demand for housing = reduce home building = reduce investment spending = shift AD in
c. Rise in housing prices raises household wealth-households feeling wealthier increase consumption spending = shift AD out
d. Business confidence falls lower spending on new equipment-lower equipment spending = lower I spending = shift AD in
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Generalization: Single Shift
Price Level GDP
AD -
AD -
AS -
AS -
Based on what you have done, fill in the following table
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Questions
a. What happens when oil prices rise and war spending rises?
Get out that pad and draw the diagram before reading on
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Questions
b. What happens when productivity rises and exports rise due to growth in China?
Get out that pad and draw the diagram before reading on
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See how you did
a. What happens when oil prices rise and war spending rises?
1. Oil prices rise = decrease in AS = shift AS inward2. War spending increases = increase in AD (G) = shift AD
outward
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See how you did
b. What happens when productivity rises and exports rise due to growth in China?
1. Productivity rises = increase in AS = shift AS outward2. Exports grow = increase in AD (X) = shift AD outward
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Generalizations: Double Shift
Price LevelQuantity (GDP)
ADAS
AD AS
AD AS
AD AS
Fill in this table and see what you getRemember: Double shifts mean only predict price of output